Market Anchoring

- 04 August 2010

By Carl Capolingua

“Market anchoring” is a classic case of irrational behaviour which can cost traders dearly.

It describes our tendency to become “stuck” on a particular reference point for making judgements and stock decisions and it serves as a lesson that most of traders’ problems come down to behavioural biases.

Anchors keep our mind fixed to the one spot because they are a reminder of what was originally a good idea. For example, we may anchor a trade around our entry point of a stock because the price “looked good at the time”.

A common example of this is a trader who, after buying a stock which has fallen in price, a losing trade, sticks to their entry point as a signal to exit.

Owning up to a loss is difficult and many traders latch onto their breakeven point in hope. Come hell or high water they refuse to sell until they break even!

The risk is that while you’re waiting for a losing stock to come back to breakeven, you may be waiting for something that isn’t coming – and magnify your losses exponentially. This can be especially disastrous if you are leveraged into the stock via a margin loan or CFD.

Traders with a winning mindset can accept a trading loss, a virtue separating them from poorly performing traders. Successful traders avoid anchors by listening to the market, admitting they’ve made an error in judgement and enacting their trading plan.

Traders with a losing mindset attach themselves to a desired exit point, neglecting their trading plan and important mechanisms behind the market: demand and supply go out the window, as the trader focuses on the anchor level.

Markets change and even the best traders will get it wrong – in most cases quite often. What looked good in the past may not look good in the future, and the switched on trader must respond.

Let’s look at the recent price history of BHP Billiton as an example of how anchoring can catch you out.

Say a trader came into the market in September 2007 and eyed off BHP’s stock, deciding that whilst it was trading around $45 a share, due to the miracle in China it was worth closer to $60. They buy in certain of an easy profit.

By Dec 2007, BHP’s stock plummeted to $35.

A trader anchored to the concept that “BHP is worth about $60” would hold on in the stubborn hope that their initial analysis remains intact; that the right thing to do is simply to hold and wait until the market realises the value in BHP.

After all, they tell themselves, BHP is a quality blue chip stock and it willdefinitely go back up. One only loses when one sells and therefore there’s no point selling at $35 when by simply waiting long enough, one will eventually be able to get $45 again.

By the end of December BHP is in-an-almost-vertical descent as the first rumblings of the Credit Crisis surface. With the price now at $30 and the market in a panic, the investor realises their initial analysis was incorrect and chickens out.

It’s the exact low and BHP rallies strongly to a high of $50 by May 2008!

“See, I knew it! BHP was worth $60 a share…I’m such an idiot…I knew I should have hung on!!! Ahhh I always sell at the low!”

“Well, I’m not going to make that mistake again. BHP is now at $50, I know it’s going to $60, I’ve always known it was going to $60. If I buy twice as many shares now I’ll be able to make back my losses from last time when it definitely goes to $60 this time…”

The investor piles in; this time buys twice as many BHP shares as their last bet. $50 is the exact high of BHP as the GFC obliterates any optimism over China and resources company shares tumble. By July 2008 BHP is trading at $40. The investor is staring down the barrel of another loss.

“I’m such an idiot! I’ve done it again! I can’t believe it! I always buy at the top! I must be the unluckiest investor in the world…it’s not fair the market is out to get me!

Well I’m not going to make the same mistake as last time. Last time I sold at the bottom when I should have just held on. If I just held on, BHP would have gone back up like it always does and I wouldn’t have had to take that loss.

Surely this is the bottom now; I mean BHP can’t go below $40 because it’s way too cheap here. I’ll buy a few more at $40 so that it will only have to go back up to $45 for me to break even…I promise I’ll get out there and never trade BHP again…this is a mug’s game!”

Three months later BHP is at $30 and the investor is losing over 4 times their initial loss from the first trade!

“Ahhh…I knew I shouldn’t have bought any more at $40…that’s it, I don’t care what happens, I WILL NOT SELL until I break even. I AM NOT GOING TO LOSE AGAIN. I am the unluckiest investor in the world. It’s not fair!”

A couple months later, the GFC is causing the most revered banks in the world to fail and is plunging the world’s biggest economies into recession. BHP has slumped to just $20. The investor can only see negativity in the press and their mind is boggling at prospect of a prolonged global depression. Their loss is staggering, but now they realise it could get a whole lot worse.

“I just wanted to make back my first loss. I just wanted to make $10 on BHP. Now I’ve lost $40 per share on twice the amount!! It’s so unfair. BHP is the worst company in the world. I knew I should have gotten out at $30. I can’t believe this is happening again.

“Well that’s it. I’m not playing this game anymore. BHP, nay, the whole market can go to hell! You’re not getting any more of my money. I’m getting out here and that’s it, I’m not even going to look at the market again. I’ve always said this is a mug’s game.”

The investor finally admits defeat and sells at $20. This is the exact low price of BHP. The worst of the GFC storm passes, sanity returns to the markets and prices around the world bounce. Economies stabilise and recover, and within a year BHP is trading at $40 again.

Perhaps you can relate to the above story, or your own personal version of it. If you can’t then there’s a chance you just haven’t been in the market long enough yet! The best traders in the world have faced these exact scenarios, many times and have still gone on to make fortunes.

What makes them different from the average punter? Well, eventually, after making the mistake our punter did above, they learn it is far better to cop a small knock on the chin than to hang onto a losing investment and experience the death blow.

Traders who have a winning mindset do not fall prey to anchoring. They understand that the biggest threat to their profitability is taking big losses. The best way to ensure one takes a big loss to be completely inflexible to the possibility that one is wrong, and that the price may never get back to one’s breakeven point.

Even if it does, who is to say that one will have the intestinal fortitude to ride the storm from peak to trough and back to peak again? Further, how many other opportunities will one miss while they’re holding on to that burgeoning loss? Finally, what is the emotional and long-term psychological impact of holding a loser all the way down? It’s just not worth it.

The best traders, the winners, are ironically the best losers; those who can take a small loss in order to avoid it becoming a big loss. Losing investors can’t admit they’re wrong by taking a loss when it is still small. This ensures that they end up taking big losses and cements them as losing investors.

Traders need a proven process to counter negative emotions and behavioural biases; this will make it easier to swallow a loss, lead to better profits and avoid you being snagged with needless anchors. We’ll discuss further in next week’s Marketpulse.

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